SEC Hits Pause on Approval of 4x ETF
Quadruple-Levered ETF? SEC Hits Pause on Its Approval of an Exotic Investment
Commissioners’ review could reverse or uphold earlier decision by the SEC’s staff to approve the risky, new products
The U.S. Securities and Exchange building in Washington. Photo: Stephen Voss for The Wall Street Journal
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The Securities and Exchange Commission will reconsider its initial approval of a risky, first-of-its-kind exchange-traded fund that promises four times the daily price moves of S&P 500 futures contracts, according to people familiar with the matter.
The commission’s decision means the earlier approval—given by the SEC’s staff, not the politically appointed commissioners—has been put on hold and doesn’t allow the ForceShares Daily 4X US Market Futures Long Fund and Short Fund to begin trading, the people said. The commission, which currently has three members, ultimately could reverse or uphold the staff’s decision, but the move puts more scrutiny on a product approval that took many by surprise.
“I was surprised they [the staff] let them go,” said Amy Doberman, a partner at Wilmer Cutler Pickering Hale & Dorr LLP who was previously general counsel of ProShares, a leveraged ETF provider. “They are certainly not any less risky. I cannot imagine they are going to be any less susceptible to the impact of volatility that caused issues with the other [leveraged] funds.”
The SEC’s approval of the 4X funds on May 2 appeared to signal that the SEC’s view of risky ETFs had changed after former Chairman Mary Jo White stepped down in January. Ms. White led an effort to crack down on the use of leverage by mutual and exchange-traded funds, but the approach wasn’t popular with Republican lawmakers or regulators.
Leveraged ETFs employ derivatives to deliver two or three times the daily price moves of benchmarks. The ForceShares quadruple-leveraged funds would be the first to move beyond triple leverage.
There are 273 leveraged, inverse or leveraged inverse exchange-traded products on the market, with a collective $44 billion in assets, according to market data firm XTF. While that represents just 1.5% of the total $2.9 trillion of U.S. ETF assets, many leveraged and inverse ETFs are heavily traded on U.S. exchanges.
Leveraged ETFs are marketed as tools designed for short-term trading. Securities regulators have been cool to leveraged ETFs for several years, even though they approved them a decade ago, warning repeatedly that owning such products for longer than one day can lead to surprises. The SEC warned brokers in 2012 that leveraged ETFs are potentially “unsuitable” for long-term investors. Morgan Stanley agreed in February to pay $8 million to settle SEC claims that it didn’t properly oversee sales of inverse ETFs to clients.
ForceShares is a first time ETF sponsor that worked with ETF Managers Group LLC, a firm that provides services to aid smaller sponsors in launching new ETFs. A principal at ForceShares couldn’t be reached for comment. A spokesman for ETF Managers Group declined to comment.
An SEC spokeswoman didn’t immediately respond to a request for comment.
In December 2015, the SEC proposed a rule that would have made it much more difficult for triple-leveraged and triple-leveraged-inverse ETFs to be sold as mutual funds to retail investors. The rule proposal sought to significantly scale back the exposure that mutual funds could have to derivatives, which provide the rocket fuel that allows leveraged funds to generate exponential returns. The rule could have resulted in closures or forced modifications of dozens of leveraged ETFs.
ForceShares’ products wouldn’t have been subject anyway because they aren’t registered under rules that govern traditional mutual and exchange-traded funds. The company’s 4X fund structure instead was presented to regulators as a type of commodity product that doesn’t need to meet the same standard of investor protections that mutual funds must offer, such as oversight by independent boards of directors. That means some large brokerages might not have been willing to recommend ForceShares’ 4X funds to retail investors, out of concern that regulators would find them too complex for mom and pop traders.
ForceShares’ application could have escaped the attention of commissioners before its approval because the SEC staff has the authority to make some decisions on its own. SEC commissioners can move to review those decisions, including the approval of new products.
The review requires the SEC to consider a new round of comments from the public, which means the application may get more notice this time from competing ETF sponsors as well as some of the consumer groups and Wall Street watchdogs that typically weigh in about new, complex products.
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